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Oil & Gas Majors |
Is the Energy Bull Dead
For now he is dead, but he shall re-incarnate and run again. And, even as he dies, he shall not visit the depths of hell for a long, long time. When demand for oil is perceived as rising and production is at existing capacity, a cut by OPEC puts a firm floor under prices. When demand for oil is perceived as falling and production is below existing capacity, a production cut will lead to quite the opposite; prices will fall because there is the comfort that future increase in demand can be met from existing capacity. Medium term, demand will rise but there are increases to existing production coming up from Angola, Brazil, GOM and Saudi; supply and demand is well balanced. In such situations, oil should trade at close to the demand led equilibrium (marginal cost of production) - approximately $60. Oil could get over-sold on recession fears, but I do not see it falling below $50. I would look for average prices of $100 over the course of the coming 5 years.
When the economic expansion starts (and this is inevitable - it is a question of when not if), oil will rally sharply from a higher base. While I do not expect it, I would not be surprised to see oil hit $200 when growth in perceived demand rises above existing production capacity. Basic materials and energy are in a very strong fundamental position because of Emerging Market demand and this will last several years. Oil prices are going to remain high for a while yet - the inflation adjusted historic price which is at over $100 is not an unreasonable estimate/price target. What can reduce oil price expectations? (a) Long term demand destruction - unlikely due to EM growth (b) Significant energy alternatives - unlikely until oil prices are at economically un-sustainable levels for a long period of time. A major and meaningful shift to nuclear, battery operated cars, improved solar technology, wind technology, hydro technology, will only occur in response to meaningful economic hardship caused by oil prices. Given that energy intensity {% of energy component in each $ of GDP} is low in the developed world, oil price does not matter as much as it has in the decades past. Price does matter, but it is unlikely to cripple the global economy at $100/$120 price levels. (c) New supplies coming from E&P activity including ultra deepwater exploration to exceed elevated demand from EM's. What is visible is likely to keep demand and supply in balance but we are certainly not yet at a point where there will be excess capacity anytime soon. (d) New drilling technologies to reduce producer costs. Again, there is nothing new on the horizon; dual drilling tables and dual stack technology on semi submersibles & drill-ships have already been in place several years. The sixth generation rigs now arriving on the market focus more on improving access to hitherto un-explorable areas - it will be possible to drill in deeper water; it is not an innovation aimed at reducing producer capex. Producer capex inflation is running at 12% and producer opex inflation is running at 6%; the latter will moderate very fast after oil prices fall. But the former will moderate only after 2012 when new drill rig availability to match demand is on-market. There is and has been heavy new build activity since 2003, once these rigs are available utilization ratios will come down from 100% and that is when you will see capex pressure on produces pull off because day rates on ultra deepwater assets will ease from historic highs we see today. This downturn in oil is economic cycle related. It does not mark the end of an era of fundamental strength for the sector.
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